Currency Risk: To Hedge or Hedge Not?

Between 1994 and 2004, the value of products imported into North America more than doubled, rising from $928 billion to about $2 trillion. During the same period, product exports also grew dramatically, jumping from $739 billion to $1.324 trillion, according to the World Trade Organization. As the volume of cross-border transactions has skyrocketed, however, many North American companies have failed to adopt policies for hedging their exposure to fluctuating foreign exchange (fx) rates.

Historically, North American organizations could grow sufficiently by focusing on domestic markets. Executives had little reason to learn the ins and outs of foreign currencies. So today, when these companies do conduct cross-border transactions, many of their managers ignore tools such as forward contracts and options that could protect their firm's bottom line against changing currency values. Of the 100 U.S. and Canadian finance professionals responding to a 2004 survey by Travelex Commercial Foreign Exchange, a New York City-based company, 70 percent said that their business did not use hedging tools to protect against foreign currency risks, and about two-thirds said that their organization lacked an fx policy.

Some finance executives believe they can mitigate their company's fx risks by setting all prices in U.S. dollars. That thinking doesn't hold up, says Bob Murray, senior vice president and managing director of foreign exchange with Sovereign Bank in Boston. "Even if you bill or pay in dollars, you're not mitigating the currency risk," he explains. After all, someone has to convert the invoice or payment into the local currency. Doing business only in your company's home currency allows the counterparty to determine the exchange rate. And it's not uncommon for that entity to build into the price a premium for its own exposure to currency fluctuations, Murray says. In addition, a company loses a competitive edge when it deals only in one currency, says Kevin Kilkelly, director of treasury operations with Symbol Technologies Inc., an enterprise mobility company based in Holtsville, N.Y. "You could risk market share if your competitor is offering to bill in euros and your customer prefers that." Symbol Technologies generated about 42 percent of its $1.8 billion in revenue outside the United States in 2005.

Some treasurers eschew hedging instruments out of concern about the cost or effort hedging entails. "A lot of companies avoid using options," says Jiro Okochi, CEO and co-founder of Reval.com Inc., a New York City-based provider of derivative risk management solutions. "It may be because of the more complex hedge-accounting issues or the negative connotations of paying a premium" to purchase an option. Quite a few finance executives assume that hedging is more expensive than it's worth. Sometimes that's true; hedging is often proportionally more expensive for smaller and midsize businesses than it is for larger organizations, says Wolfgang Koester, CEO of Scottsdale, Ariz.-based Rim-Tec Inc., which provides foreign currency management services for midmarket companies. For instance, a bank may charge a company more if it purchases hedging instruments infrequently rather than on a regular basis, Koester says.

Despite the concerns some treasurers have about hedging, simply ignoring their company's exposure to foreign currency fluctuations is not a good idea. Sixty percent of the respondents to the Travelex survey indicated that changing fx rates could have a material impact on their organization's financial results. Shay Brennan, vice president of currency risk management at Anglo Irish Boston Corp. in Boston, says that the average change in value of the euro is about 10 percent per year. Between 2003 and 2004, the euro strengthened by 9.9 percent against the U.S. dollar, according to the International Monetary Fund (IMF). Given that many companies operate on margins of 4 percent to 5 percent, a move in a currency's value of even a few percentage points the wrong way can wipe out a year's earnings.

Nondeliverable Forwards

One variation on the typical forward contract is the nondeliverable forward, or NDF. Companies use this instrument to hedge exposure to currencies of countries such as China and India that are restricted and therefore traded only within their respective borders.

Bob Murray, senior vice president and managing director of foreign exchange with Sovereign Bank, provides an example. Say a company with a sales operation in China wants to hedge its exposure at 8 yuan to the dollar for six months. Today the organization buys 8 million yuan from its bank for $1 million. The bank agrees to buy back the yuan at the prevailing exchange rate in six months. "There's no movement in the foreign currency, just U.S. dollars move back and forth," says Murray.

The company is protected no matter which way the yuan moves. If the yuan strengthens and the company loses on the transaction, earning a return under 8 yuan per dollar in six months, its operations in China will benefit from the strengthening currency. On the other hand, if the company can buy back the yuan more cheaply, it gains on the transaction.

Developing an Effective Hedging Policy

The first step in managing foreign exchange risk is to identify where, exactly, your company is exposed to currency fluctuations. But zeroing in on an organization's fx risks can get complicated. A business may manufacture in some countries and distribute and sell in others. And receipts and expenses may come in at varying times.

Nevertheless, anecdotal evidence shows that American treasurers are beginning to establish programs to better identify and manage their exposures, says Ian Taylor, senior vice president of global sales and marketing with Custom House, a foreign exchange provider headquartered in Victoria, British Columbia. "We're seeing American companies getting more attuned to global currencies." Taylor believes the rise in global trade and the decline of the U.S. dollar are driving this shift. Since 2001, the dollar has fallen about 40 percent against the euro, according to the IMF. As a result, some North American businesses are finding that their foreign trading partners now request payment in euros or other currencies.

One business that pays close attention to currency risks is Lincoln Electric, a manufacturer and reseller of welding and cutting products worldwide. The Cleveland-based company has operations in the United States, Canada, Europe, Asia Pacific and several Latin American countries. Its policy is to hedge at least half of its exposure to another currency once that exposure exceeds a predefined threshold. "Our baseline that senior management wants to cover is a minimum of 50 percent for nine months," says Dwayne Petish, international treasury manager.

To determine the company's exposure, Petish reviews monthly reports from each operation and nets out any intracompany differences. For example, if an operation in France is short on U.S. dollars -- that is, its expenses in dollars exceed its dollar-based revenue -- while a plant in Germany is taking in more dollars than it's spending, Petish hedges the difference, which is the company's overall exposure.

In addition to tracking the markets daily and netting currencies monthly, Petish prepares a quarterly report for senior management that summarizes all of Lincoln Electric's global exposures. "Senior management signs off and approves what we'll be hedging for the next period," he says. That way, everyone who should know what the company is doing to hedge its exposures is in the loop.

Companies that do business overseas need to follow Lincoln Electric's lead and develop a coherent foreign exchange policy that outlines the exposures the company wants to protect itself against and how it will hedge to offset them. "The biggest pro of this is the discipline it enforces," says Ira Kawaller, president of Kawaller & Co., a consulting firm in Brooklyn, N.Y., that focuses on derivative instruments for managing financial risk. "If you don't have some kind of rule, you're left with people working by the seat of their pants."

A clear hedging policy reduces the temptation to play the market. Without one, treasurers might decide, for example, to wait to pay an invoice until they see whether the exchange rate will move in the company's favor. Market-timing tactics sometimes work, but they can lead employees to take risks corporate executives wouldn't accept. A clear policy also reduces the temptation for employees simply to do nothing. Absent any instructions from senior management, many employees will avoid any hedging transaction that they fear may not be needed. "There's a lot to be said for certainty, for being able to say, 'Our objectives are clear, and this is what we're trying to do,' " says Humphrey Percy, chairman of SGM-FX, a London-based foreign exchange firm.

That's not to say a policy should leave no room for flexibility. At times, Petish works with Lincoln Electric's management to determine whether tweaking the company's coverage ratio would make sense based on current exchange rates. For instance, the company's sales and manufacturing operations in Poland are growing. Because of this change in the business and the strengthening Polish zloty, Lincoln Electric's exposure to the zloty increased nearly 40 percent during the latter half of 2005. As a result, Petish and his colleagues decided to increase coverage of the exposure from 50 percent to 75 percent for the next nine months.

Sometimes a business can use "natural hedges": revenue the company obtains in a particular foreign currency closely matched to the expenses the company incurs in that currency. That's the case with Cambridge, Mass.-based Pegasystems Inc., a $100 million provider of business process management software. About one-third of the company's revenue comes from outside the United States. "When we receive foreign currency for sales, we use that to offset expenses," says Edward Corbosiero, director of treasury and taxation. Leveraging natural hedges is less expensive and time-consuming than purchasing instruments to protect against a currency exposure.

Although Pegasystems has never bought hedging instruments, it has prepared a hedging policy in case manage- ment takes an action such as ramping up operations in another country. "We're prepared," Corbosiero says. "The guns are loaded, but we don't have to shoot them."

Choosing the Right Tools

Forward contracts are the most popular hedging instrument. They allow companies to lock in an exchange rate ahead of time, which "takes out the element of surprise" and enables the company to more accurately forecast, says Mark Warms, the London-based global head of sales and marketing with FXall, a foreign exchange trading portal. Here's how a forward contract works. To lock in the current dollar-to-euro fx rate for a year, a treasurer buys a forward contract for 1 million euros at that rate. By doing so, she simplifies financial planning. Her organization then can use the euros as needed.

A forward contract with variable delivery dates provides as much protection as many companies need, according to Sovereign Bank's Murray. "We use forward contracts," says Symbol Technologies' Kilkelly. "We don't rule out using other instruments, but typically this is the cheapest way to hedge exposures." What's more, forward contracts don't require the buyer to pay a premium up front, Kilkelly says. Instead, when the time comes to settle the contract, the opening and closing levels of the hedged currency are compared. If the company has gained, the counterparty pays the difference; if the company has lost, it pays the counterparty.

Although forward contracts are the most commonly used hedging tool, the volume of fx hedging possibilities is increasing, Brennan says. For example, as their name implies, options offer companies the right, but not the obligation, to buy or sell a currency on a certain day. Options typically aren't a beginner's hedging tool. One reason is that determining the price, or "premium," a company is paying for the option can be difficult because factors including the current price of the currency, the length of time until settlement, and the volatility of the market all influence the option price, Murray says. Plus, some treasurers find that their bosses resist writing a check for an option that they might never use.

One way to gain the benefits of options, yet keep premium costs down, is to adopt "structured hedging." A structured-option hedge reduces or even eliminates the premium, Brennan says. In one variation, the price of the contract is wrapped into the rate the company pays for the currency. For instance, a treasurer may want to be able to pay $1.20 for each euro that it purchases at a later date. Instead of directly paying a premium for the option, the treasurer may enter into an option structure that allows him to pay a maximum of $1.22 for the euro. And, the agreement is structured so that if the value of the euro has dropped below $1.22 when the option expires, the treasurer can buy half the euros at $1.22 and half at $1.20.

Structured options can become complicated. Don Lloyd, vice president of risk solutions at Travelex, offers an example. Company A buys a call option to purchase euros at $1.22 in six months at the same time it sells a put option to Company B that allows Company B to sell euros to Company A at $1.16 if the euro drops below that rate. The company sets a price for both deals so that the premium it earns on the sale of the put option equals the premium it pays on the call option. Company A has effectively locked in a euro rate of $1.16 to $1.22 for six months at no cost.

Establishing an fx policy and choosing hedging tools can be daunting. However, even companies that currently transact business only within the United States ought to understand the foreign currency markets and the hedging tools available. Markets such as India and China are growing at several times the rate of the U.S. economy. "The bigger risk is in not being in these markets," says William Wilson, chief economist with Keystone India LLC, a Chicago-based consulting firm. Executives need to decide which markets their organization should be in, then take steps to manage the currency fluctuations. Those who don't are taking on risks they're likely not aware of.

The Impact of Technology

Technology has had a huge impact on the way companies manage their foreign exchange exposures. Treasurers now can use trading portals to easily access information on the market prices of various currencies. Until several years ago, it was hard for treasurers to obtain data on the trading levels of specific currencies. As a result, companies often paid more than necessary for their trades.

"Get in touch with the markets; know the different currencies and what to look at," advises Dwayne Petish, international treasury manager with Cleveland-based Lincoln Electric. Access to a system that provides current pricing data, such as Reuters or Bloomberg, is key, he adds. Although these systems typically cost in the tens of thousands of dollars, they help companies save money because treasurers can find out what they should be paying for a particular currency. "If you don't have a system, you're at a disadvantage," says Petish. Treasurers can also use electronic trading systems to execute foreign currency trades online. As recently as five or six years ago, most trades were completed by phone -- a time-consuming manual process, according to Mark Warms, global head of sales and marketing for London-based FXall.

Technology can also help companies comply with FAS 133, which went into effect in 2001. This regulation established accounting standards for derivatives such as foreign currency options, and it requires that hedges be tied directly to the company's foreign exchange exposure. "The complexity of FAS 133 led us to look for a software solution to manage the reporting requirements," says Sheila Johnson, director of treasury with Hollister Inc., a Libertyville, Ill., manufacturer and marketer of medical devices. The company, which sells into 90 countries, implemented Reval's HedgeRX system in 2002. Johnson accesses the system to obtain valuations of hedging instruments that Hollister uses to protect its fx exposure at the time the company purchases an instrument and on a regular basis thereafter. Reval provides daily valuations instead of the month-end valuations provided by Hollister's trading partners. Says Johnson, "This gives Hollister the ability to make daily decisions on our hedging program."